Ways Government Improves Efficiency

Social and Economic Policy as a means to greater Efficiency and Production

The argument that government is always an obstacle to Economic efficiency and productivity is the foundation of Market Fundamentalism and Conservative ideology. The following arguments and examples are outright refutations to this myth.

A particularly deplorable form of waste is caused by discrimination against minority or female workers. When a job is given, for example, to a white male in preference to an African-American woman who is more qualified, society sacrifices potential output and, the entire community is apt to be affected adversely. Every one of these inefficiencies means that the community obtains less output than it could have, given the available inputs. (Economics Principles and Policy – pg 47)

Here is a principle example of where Government “interference” certainly improves the efficiency of the market, resulting in more production for everyone. Capital or labor that is not being utilized to its full ability is production left on the table. Hiring someone less capable than another person based on color, leaves the more productive person without work, and his greater capability is left out of the economy, resulting in production below the possibilities frontier. Government’s laws against discrimination help to insure that trivial objections to hiring are left out of the Calculus, so that productive capability is used as the hiring mechanism, not color or race. We get more “production” as a result, and an output closer to the production possibilities frontier.

Limited Liability Laws

Capitalism requires capital – lots of it. But without limited liability laws, investors are unlikely to risk investing their money in businesses. In the 19th century, before the passing of laws that limited the liability of investors, anyone who put money into a business that then went under could be held liable for the debts of the company. They could have their personal assets seized and could be financially ruined. Needless to say, this discouraged investment. Without limited liability laws, the economy would not have access to the capital it needs to grow and prosper.

Free from the risk of being mired inf crushing debt or freedom or property seized and destroyed, investors gain a confidence to actually invest and become entrepreneurs without worry of ruin. You are liable for what you invest, but you are protected to a certain extent by laws that determine limits to your liability. Inhibiting risk encourages more investment and thus more growth and prosperity.

Business is inherently risky and one of the largest risks is business failure, particularly during recessions and depressions. In the 19th century, before the creation of bankruptcy laws, business failures would usually saddle entrepreneurs with large and ongoing debts, making it impossible for them to make a fresh start and often putting them in debtors’ prison. Investors and creditors also often failed to get any of the money due to them. Bankruptcy laws protected otherwise healthy businesses that were temporarily short of funds. And these laws allowed entrepreneurs to be eventually freed from crushing debts. Along with limited liability, bankruptcy rules formed a crucial financial safety net for entrepreneurs. It is important to note, however, that bankruptcy laws were passed not simply out of concern or sympathy for failed entrepreneurs, but also as a way to lessen economic risk and therefore encourage more investment and economic growth.

Without reliable money, markets would be based primarily on barter and thus be extremely limited. In the U.S., before the Civil War, almost all paper money was issued by private banks – not the government. This was an unreliable and incredibly chaotic system. Sometimes merchants would not even accept certain currencies. It also meant there was no real control over the money supply – which has a crucial impact on inflation and economic growth. Widespread commerce and a stable economy both require a stable and dependable money system – one in which consumers and merchants have faith. This can only be provided and maintained by the federal government.

Of course the Libertarian will laugh and scoff at the idea of “stable” because they are unable to talk about more than three things, one of them being inflation. Yet they still manage to do this over computers, houses in nice heated residences, with food all around them in nice chairs and big screen TVs nearby. It works, and the entire underpinning is a pragmatically stable money supply. Try bartering with chickens or carriage bolts and see how fast transactions can take place. Lets see how “efficient” all of that would be.

Furthermore, we even have one of their personal hobby horses, “money issued by private banks” addressed here. It was unreliable, chaotic, and many merchants would not even accept the currencies. Its so easy to take for granted the fact that every time you use money you earned it works – without the government you complain about so much, you would be spending time trying to barter and find a merchant to take your money for trade. Money works only insofar as there is confidence in it – and only the Government so far, has been able to provide such currency.

Patents and Copyrights

Large portions of our economy would grind to a halt if the government did not grant patents and copyrights. Without this massive intervention into the free market, the drug, music, publishing, and software industries could not exist. Bill Gates likes to think of himself as a self-made man, but he would not be one of the richest men in the world if the government did not make it illegal for anyone but Microsoft to copy and sell Windows.

This is one example of countless. Investors have confidence to take the risks they take on their livelihoods based on returns off ideas that can’t be stolen.

Banking Regulation and Insurance

As we have seen recently, a capitalist economy depends heavily on stable banks to finance growing businesses. But banks are inherently vulnerable to “runs” – where worried depositors all seek to take out their money at the same time. Banks cannot survive runs because they have loaned out most of the money deposited with them and therefore cannot pay it out to a large number of depositors at once. Before the passage of banking regulations and federal deposit insurance, banks regularly had runs and failed. The main reason that we had no disastrous runs on banks (and money market funds) during the financial panic of 2008 was that government was there to guarantee those deposits.

Imagine sleeping every night wondering if your money was going to be in the bank in the morning. In today’s world, you don’t have to worry about that. It’s something that is easy to take for granted because you never notice when something “doesn’t” go wrong.

Market Failure

Market failure is a concept within economic theory describing when the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off. (The outcome is not Pareto optimal.) Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view. It is a clear example of where economic and social motives often diverge – a failure of market fundamentalism and ethical egoism, the idea that if people only pursue their self interests, the aggregate outcome will be good for everyone.

The problem with market fundamentalism is the problem with all forms of fundamentalism – the faith of the adherents blinds them to significant portions of reality. In the case of market fundamentalism, it blinds them to most of the serious problems inherent in a capitalist economic system – the problems that necessitate government action. If pressed, most conservatives will admit that unregulated markets do suffer from a few “market failures,” such as a tendency to ignore pollution. But they see such failures as episodic and limited. For them, these problems only occasionally interfere with the smooth operation of markets to produce the public interest and thus only necessitate a modicum of government interference to set them straight. But they are wrong. The failures of markets are many, serious, widespread, and ongoing. This is not to suggest that capitalism is “bad” or to deny the many economic advantages and achievements of markets. It is simply to acknowledge that when left on their own, market economies will inevitably produce a whole host of economic and social problems.

The simple reality is that these things just matter. And the wording is brilliant. Market Fundamentalism is indeed faith that blinds them from very important portions of reality. If you really believe the market can do no wrong, you’re not going to be open to a solution to solve a problem when one does arise. The tendency to blame everything on the victim himself is faulty – if people are always at fault, why can we trust the aggregate of their decisions any better? Market Failure is one of the most important and pervasive problems in all of economics. Addressing them, and limiting the scope of their harm, is one of the most important pathways to increasing societal well being.

Natural Monopolies

Economic justifications for regulation derive from the theories of market failure that were introduced in the last chapter. To review, even if we assume that most goods and services will be produced as a result of private voluntary transactions among individuals in a free market, there are certain situations when the market by itself will fail to produce certain goods and services adequately and efficiently. We already have examined how the market fails to produce certain public goods, in general, and the need for a range of government actions to provide for them. Government regulation is usually justified in the case of three particular market failures: monopolies—natural and anticompetitive, imperfect information, and externalities. As noted earlier in the case of utilities, a natural monopoly is a product or service that a single producer can create more efficiently and cheaply than if multiple producers competed to provide the service. Economists point out that, unlike goods produced in competitive markets, in natural monopolies the average cost of goods produced declines as output increases.14 For example, once I invest in the generators and transmission lines for providing electricity to a town each customer added to the grid makes the cost per person served lower. In this situation, I always could offer a lower price for my service than any competing company that might want to make the huge investment in a second grid to serve the customers not yet connected to my grid or to lure any of my customers away. The existence of natural monopolies poses a problem for consumers who are supposedly “sovereign” in market economies because they have no alternative providers of goods they consume. In the case of natural monopolies, that market sovereignty dissolves, as they are at the mercy of a single firm and any price it wants to charge. Regulation, in this case, is expected to replace the absence of market competition. Government regulators make sure that the monopoly good is produced in a way that is fair to both the producer, in the form of fair return on investment, and the consumer, in the form of an affordable price. (Libertarian Illusion, pg 84)

Predatory Pricing and Barriers to Entry

Markets where one or a few firms obtain overwhelming control as a result of competitive forces also justify regulation. This sort of monopoly places consumers at the mercy of a single or handful of firms that, without significant competition, can set high prices and are under no pressure to produce quality products or services. Anticompetitive monopoly power also places such firms in a position to engage in predatory pricing—prices set temporarily below the actual cost of production—to prevent any potential competitors from entering the market. The purpose of antitrust laws is to prevent such a situation from developing in a particular industry. These and other regulations, also, aim to regulate practices, like predatory pricing, that interfere with healthy competition. (Libertarian Illusion, pg 85)

Information Asymmetry

Just as natural and anticompetitive monopolies undermine consumer sovereignty in unregulated markets, consumers who lack information about the products they buy cannot control adequately the quality of products or services available to them. When the pipes in my house start to leak, I will want to hire a plumber whom I know will be competent to fix them (and not do additional damage to the plumbing in my old house). For someone as unhandy and unknowledgeable about plumbing as I am, state licensure of plumbers offers some assurance that hiring a licensed plumber to do the work will result in a competent job. Of course, if plumbers were not licensed I could rely on recommendations from friends or referrals from previous customers, data available in a market (and that I would use even in hiring a licensed plumber); but in an emergency obtaining such information may not be possible, nor may the advice of my equally plumbing-challenged friends be all that reliable. State licensure of plumbers provides some assurance that those offering their services in this area meet certain minimal standards of competence. Moreover, the plumber I hire will know that failure to do a competent job might put his license in jeopardy—an incentive for conscientious work. What applies when I want some pipes fixed applies as well to the heart surgeon who might be needed to unclog my internal plumbing. With many technically complex products on the market in a modern economy, none of us has the competence or ability to evaluate the quality and effectiveness of many of the things we buy. Market theory assumes that consumers will be competent to judge by themselves whether product A or product B best satisfies their wants and needs. This competence may come from previous experience with a product or an ability to evaluate its quality directly. For much of what we consume today, this cannot happen because of the complicated character of a product and the complexity of production systems. Much of the food we consume today, for example, includes additives and ingredients we cannot be aware of unless regulations require their disclosure. In the case of medicines, no one can be sure that a pill taken to treat a disease will be safe and effective without some regulatory oversight. Few of us would be willing to acquire information about our medications based on trial and error—such a strategy might prove fatal! Often, requiring disclosure of information regarding ingredients or methods of production may be adequate for addressing this market failure, but review of products prior to sale or mandatory withdrawals of products proven unsafe are needed. Agencies like the FDA and CPSC utilize these methods to compensate for the market’s failure to provide sufficient consumer information. (Libertarian Illusion, pg 85)

Negative Externality

In Economics, an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit. Market signals don’t capture all of the costs of the creation of the product, some of which are born by non consenting parties. It is a classic market failure.

Voluntary exchange is considered mutually beneficial to both parties involved, because buyers or sellers would not trade if either thought it detrimental to themselves. However, a transaction can cause additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees kept for honey that also pollinate neighboring crops). Neoclassical welfare economics asserts that, under plausible conditions, the existence of externalities will result in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, whereas those who enjoy external benefits do so at no cost.

A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly defined property rights, as with, for example, pollution of bodies of water that may belong to no one (either figuratively, in the case of publicly owned, or literally, in some countries and/or legal traditions).

Most Autrian Economists and many Libertarians espouse that externalities only exist due to lack of clearly defined property rights. But this does not address the problem in the sense that some areas of “property” cannot be clearly defined, or that the party infliction the externality is not entitled to do so. Coase Theorem is a common solution offered by Austrians and Libertarians, where the two parties would negotiate a price to allow the negative effect to continue. A party can pollute if those suffering are compensated accordingly to make it worth the suffering. However, this places a party in a position to extort money from others at will – I have an inherent need to hit people in the face or pump foul smelling smoke into the air, or perhaps play deafening loud music at 3am while you are trying to sleep in the apartment next to me. Pay me money or won’t stop hitting you, making you sick, or ruining your livelihood.